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If you are in the DeFi space, chances are you have come across the term “impermanent loss”. This is an important concept for investors to understand related risks when participating in decentralized finance.
In this blog, we discuss what is impermanent loss in crypto and its tax implications in detail. We also explain a few solid tips so that you can avoid an impermanent loss as a crypto investor.
Impermanent loss is the apparent loss that you incur when you provide liquidity to the DeFi liquidity pools you are participating in, and the profit you earn from staking the tokens in the pool is less than what you would have earned if you held them yourself.
It happens because the market price of the deposited tokens at the time of withdrawal changes compared to your deposit time. The more the price changes, the greater the impermanent loss incurred.
This loss is called “impermanent” because you may recover the losses if you don’t withdraw your assets and their market price returns to your initial purchase price.
This is because the trading fees earned by the liquid providers each time they provide liquidity to the assets in the pool can make up for the impermanent losses. This can make the overall process profitable for the liquidity providers.
Also, you can prevent crypto impermanent loss if you just HODL your assets instead of withdrawing them during that specific time.
However, this may vary depending on the pool you are participating in, its protocols, the type of assets pooled, and the market condition.
Impermanent loss is a percentage loss you would experience if the token’s price ratio changes than at the time of deposit. Note, this is without the trading fees of the pool.
Use this formula to calculate your impermanent loss:
Impermanent Loss = (2√price_ratio / 1+ price_ratio) - 1
Where,
price_ratio is the ratio between the market price of the token at the time of deposit and at the time of withdrawal.
If you want to dive deeper, here’s an excellent derivation for the above formula.
So, impermanent losses occur when the prices of your tokens in the pool change. But how does it exactly work? Let us understand this with the help of an example.
If you have two tokens, for instance, USDT and SOL worth $1 and $20 respectively at the time of funding a 50:50 USDT/SOL liquidity pool. You have to provide an equal ratio of both tokens to the pool (i.e. tokens worth the same in fiat currency)
Let’s say you invest $1000 in the pool. Since it’s 50:50, you provide $500 USDT ( 500 USDT tokens) and $500 SOL (25 Solana tokens).
Now, if the price of the SOL increases, for instance, $22, it opens up an opportunity for arbitrage traders since the price of SOL is lower in your pool than in external exchanges. The smart contracts of the AMM are set in such a way that the token ratio in the pool remains constant.
So, when the price of SOL goes up, the amount of SOL tokens in your token pair will decrease and the USDT will increase to a point where the price of SOL and USDT becomes constant in your pair.
In this case, it will come back to equilibrium when your token pair has 524.40 USDT and 23.84 SOL. If you now decide to provide liquidity, the value of the token pair will be $1048.81.
However, if you have held the token yourself – you would have 500 USDT and 25 SOL worth $1050. You incur an impermanent loss of 0.11% from the trade even though you have realized capital gains from a tax perspective.
While you can’t avoid impermanent loss completely, here are four tips to help reduce its occurrence.
The more the price of your crypto asset changes, the greater the chances of IL. One way to avoid it is to opt for stablecoins or less volatile pairs (e.g. USDT and DAI). Since the prices of these tokens do not fluctuate much, the risk of impermanent loss significantly reduces.
Liquidity pools don't always require you to invest in 50:50 crypto pairs. Some DeFi exchanges allow you to invest in two or more tokens at varying ratios. For instance, investing in a crypto pair with 80% stablecoins and 20% volatile tokens mitigates the risk of impermanent loss since a major portion of the token price will remain stable.
Holding your crypto assets and using them in the passive income approach helps you reduce risks of several risks that come with the market volatility including impermanent loss. This also helps you reduce your tax liabilities.
Many DeFi protocols, for instance, ThorChain, have Impermanent Loss Protection (ILP) programs to ensure that the users either make a profit or at least meet the break even when they decide to liquify the pool.
This is done by filling in the loss using the decentralized protocol’s treasury. The losses are completely covered after a minimum period of holding time (i.e. 100 days) and partially covered before that point.
There are no defined rules for impermanent loss in most jurisdictions which can turn its taxes quickly complex. However, with all the information available, it can be interpreted that:
Since the tax implications on liquidity pool transactions are still in the grey area, it’s important to discuss all the details with your accountant to report taxes correctly.
To simplify the process, Kryptos automatically detects any taxable events and calculates your realized capital gains from thousands of transactions. Simply add your wallet or exchanges to the platform – the app auto-syncs your transaction history and generates tax reports that comply with your country’s regulations.
1. What is impermanent loss?
Impermanent loss is the apparent loss that you incur when you provide liquidity to the DeFi liquidity pools you are participating in, and the profit you earn from staking the tokens in the pool is less than what you would have earned if you held them yourself.
2. How does impermanent loss happen?
Impermanent loss is a percentage loss you would experience if the token’s price ratio changes than at the time of deposit. Note, this is without the trading fees of the pool.
Use this formula to calculate your impermanent loss:
Impermanent Loss = (2√price_ratio / 1+ price_ratio) - 1
3. What is impermanent loss protection?
Impermanent loss protection (ILP) is a program introduced by several exchanges and DeFi protocols which ensures the traders either make a profit or at least break even when they provide liquidity to the pool. If there’s any loss that occurs, the protocols fill it up from their treasury.
4. What does it mean for taxes?
There are no defined tax laws for impermanent loss or liquidity pool transactions. However, with current rules in place, the entire process is seen as a trade and is subject to tax as follows:
All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!
| Country | Issue | Kryptos Use Case |
|---|---|---|
| India | Cryptocurrency transactions are taxed as capital gains, with evolving legislation creating uncertainty. | Kryptos.io streamlines the process by automatically tracking transactions and computing capital gains, adjusting to new regulations for precise reporting. |
| Brazil | Cryptocurrencies are subject to capital gains tax and must be reported, posing challenges with complex requirements. | Kryptos.io simplifies compliance by offering real-time transaction tracking and detailed tax calculations, making it easier to meet Brazil’s tax obligations. |
| Nigeria | Regulatory framework for cryptocurrencies is evolving, with uncertainty around taxation and restrictions from the Central Bank. | Kryptos.io provides an adaptable solution by maintaining detailed records and generating flexible reports, helping users stay compliant despite regulatory changes. |
| USA | Cryptocurrency transactions are subject to capital gains tax, with detailed IRS reporting requirements. | Kryptos.io enhances compliance by automating the tracking of transactions and generating comprehensive tax reports, facilitating adherence to IRS requirements. |
| UK | Cryptocurrencies are taxed under both capital gains tax and income tax, requiring careful tracking and reporting. | Kryptos.io aids UK users by monitoring both capital gains and income from crypto transactions, ensuring accurate and straightforward tax reporting. |
| Australia | Cryptocurrencies are subject to capital gains tax, and users must report their gains and losses to the ATO. | Kryptos.io assists Australian users by providing seamless transaction tracking and precise capital gains calculations, ensuring efficient compliance with ATO reporting requirements. |
| Germany | Cryptocurrencies are taxed as private assets with gains subject to tax if held for less than a year. | Kryptos.io supports German users by tracking holding periods and computing taxes on cryptocurrency transactions, ensuring adherence to German tax regulations. |
| Japan | Cryptocurrency gains are treated as miscellaneous income and are subject to high tax rates. | Kryptos.io helps Japanese users by offering a detailed tracking system and calculating taxes on miscellaneous income, efficiently managing high tax obligations. |
| Scenario | Description | Kryptos Features that can be of aid |
|---|---|---|
| Multiple Exchanges and Wallets | Consolidating records from various exchanges and wallets to maintain a comprehensive overview of crypto activities. | Seamless integration with numerous exchanges and wallets, automatic import, and consolidation of records. |
| International Transactions | Managing records for cross-border transactions, including currency conversions and compliance with international tax laws. | Support for multiple currencies, efficient management of cross-border activities, accurate currency conversion for reporting. |
| Complex Transactions | Handling trades, swaps, staking, lending, and other sophisticated crypto activities. | Advanced tracking, reporting, and documentation for various transaction types. Kryptos' DeFi and NFT modules offer specialized tools for managing decentralized finance and NFT activities, ensuring precise records and comprehensive oversight. |
As Web3 evolves, managing a diverse portfolio has become complex. Kryptos simplifies this with advanced tools for real-time tracking, NFT management, and DeFi analytics. Discover how Kryptos turns challenges into strategic advantages for modern investors.
Struggling with crypto tax in Australia? Kryptos.io simplifies the process, ensuring accurate and compliant filings with the ATO. Track transactions and value assets effortlessly—make tax season stress-free.
Mastering Crypto Taxation: Navigate the Complex World of Digital Assets with Kryptos, the Ultimate Solution for Accurate, Efficient, and Future-Proof Tax Reporting.
If you are in the DeFi space, chances are you have come across the term “impermanent loss”. This is an important concept for investors to understand related risks when participating in decentralized finance.
In this blog, we discuss what is impermanent loss in crypto and its tax implications in detail. We also explain a few solid tips so that you can avoid an impermanent loss as a crypto investor.
Impermanent loss is the apparent loss that you incur when you provide liquidity to the DeFi liquidity pools you are participating in, and the profit you earn from staking the tokens in the pool is less than what you would have earned if you held them yourself.
It happens because the market price of the deposited tokens at the time of withdrawal changes compared to your deposit time. The more the price changes, the greater the impermanent loss incurred.
This loss is called “impermanent” because you may recover the losses if you don’t withdraw your assets and their market price returns to your initial purchase price.
This is because the trading fees earned by the liquid providers each time they provide liquidity to the assets in the pool can make up for the impermanent losses. This can make the overall process profitable for the liquidity providers.
Also, you can prevent crypto impermanent loss if you just HODL your assets instead of withdrawing them during that specific time.
However, this may vary depending on the pool you are participating in, its protocols, the type of assets pooled, and the market condition.
Impermanent loss is a percentage loss you would experience if the token’s price ratio changes than at the time of deposit. Note, this is without the trading fees of the pool.
Use this formula to calculate your impermanent loss:
Impermanent Loss = (2√price_ratio / 1+ price_ratio) - 1
Where,
price_ratio is the ratio between the market price of the token at the time of deposit and at the time of withdrawal.
If you want to dive deeper, here’s an excellent derivation for the above formula.
So, impermanent losses occur when the prices of your tokens in the pool change. But how does it exactly work? Let us understand this with the help of an example.
If you have two tokens, for instance, USDT and SOL worth $1 and $20 respectively at the time of funding a 50:50 USDT/SOL liquidity pool. You have to provide an equal ratio of both tokens to the pool (i.e. tokens worth the same in fiat currency)
Let’s say you invest $1000 in the pool. Since it’s 50:50, you provide $500 USDT ( 500 USDT tokens) and $500 SOL (25 Solana tokens).
Now, if the price of the SOL increases, for instance, $22, it opens up an opportunity for arbitrage traders since the price of SOL is lower in your pool than in external exchanges. The smart contracts of the AMM are set in such a way that the token ratio in the pool remains constant.
So, when the price of SOL goes up, the amount of SOL tokens in your token pair will decrease and the USDT will increase to a point where the price of SOL and USDT becomes constant in your pair.
In this case, it will come back to equilibrium when your token pair has 524.40 USDT and 23.84 SOL. If you now decide to provide liquidity, the value of the token pair will be $1048.81.
However, if you have held the token yourself – you would have 500 USDT and 25 SOL worth $1050. You incur an impermanent loss of 0.11% from the trade even though you have realized capital gains from a tax perspective.
While you can’t avoid impermanent loss completely, here are four tips to help reduce its occurrence.
The more the price of your crypto asset changes, the greater the chances of IL. One way to avoid it is to opt for stablecoins or less volatile pairs (e.g. USDT and DAI). Since the prices of these tokens do not fluctuate much, the risk of impermanent loss significantly reduces.
Liquidity pools don't always require you to invest in 50:50 crypto pairs. Some DeFi exchanges allow you to invest in two or more tokens at varying ratios. For instance, investing in a crypto pair with 80% stablecoins and 20% volatile tokens mitigates the risk of impermanent loss since a major portion of the token price will remain stable.
Holding your crypto assets and using them in the passive income approach helps you reduce risks of several risks that come with the market volatility including impermanent loss. This also helps you reduce your tax liabilities.
Many DeFi protocols, for instance, ThorChain, have Impermanent Loss Protection (ILP) programs to ensure that the users either make a profit or at least meet the break even when they decide to liquify the pool.
This is done by filling in the loss using the decentralized protocol’s treasury. The losses are completely covered after a minimum period of holding time (i.e. 100 days) and partially covered before that point.
There are no defined rules for impermanent loss in most jurisdictions which can turn its taxes quickly complex. However, with all the information available, it can be interpreted that:
Since the tax implications on liquidity pool transactions are still in the grey area, it’s important to discuss all the details with your accountant to report taxes correctly.
To simplify the process, Kryptos automatically detects any taxable events and calculates your realized capital gains from thousands of transactions. Simply add your wallet or exchanges to the platform – the app auto-syncs your transaction history and generates tax reports that comply with your country’s regulations.
1. What is impermanent loss?
Impermanent loss is the apparent loss that you incur when you provide liquidity to the DeFi liquidity pools you are participating in, and the profit you earn from staking the tokens in the pool is less than what you would have earned if you held them yourself.
2. How does impermanent loss happen?
Impermanent loss is a percentage loss you would experience if the token’s price ratio changes than at the time of deposit. Note, this is without the trading fees of the pool.
Use this formula to calculate your impermanent loss:
Impermanent Loss = (2√price_ratio / 1+ price_ratio) - 1
3. What is impermanent loss protection?
Impermanent loss protection (ILP) is a program introduced by several exchanges and DeFi protocols which ensures the traders either make a profit or at least break even when they provide liquidity to the pool. If there’s any loss that occurs, the protocols fill it up from their treasury.
4. What does it mean for taxes?
There are no defined tax laws for impermanent loss or liquidity pool transactions. However, with current rules in place, the entire process is seen as a trade and is subject to tax as follows:
All content on Kryptos serves general informational purposes only. It's not intended to replace any professional advice from licensed accountants, attorneys, or certified financial and tax professionals. The information is completed to the best of our knowledge and we at Kryptos do not claim either correctness or accuracy of the same. Before taking any tax position / stance, you should always consider seeking independent legal, financial, taxation or other advice from the professionals. Kryptos is not liable for any loss caused from the use of, or by placing reliance on, the information on this website. Kryptos disclaims any responsibility for the accuracy or adequacy of any positions taken by you in your tax returns. Thank you for being part of our community, and we're excited to continue guiding you on your crypto journey!
As Web3 evolves, managing a diverse portfolio has become complex. Kryptos simplifies this with advanced tools for real-time tracking, NFT management, and DeFi analytics. Discover how Kryptos turns challenges into strategic advantages for modern investors.
Struggling with crypto tax in Australia? Kryptos.io simplifies the process, ensuring accurate and compliant filings with the ATO. Track transactions and value assets effortlessly—make tax season stress-free.
Mastering Crypto Taxation: Navigate the Complex World of Digital Assets with Kryptos, the Ultimate Solution for Accurate, Efficient, and Future-Proof Tax Reporting.
